Over the last few weeks, and accelerating late last week and early this week, it looked as if a full bore run on emerging markets was in progress. Now with the yen taking its biggest dive in two decades and carry trade unwinds a temporary thing of the past, emerging market and currencies are staging a peppy rebound.

While some argue the crisis has passed, others are not so certain. This comment came as an aside in a Financial Times story today on the slingshot recoveries today:

Themos Fiotakis, economist at Goldman Sachs, said that in spite of the strong rally in risky assets, global uncertainties remained. “In a typical emerging market crisis, central banks would raise rates,” he said. “This would stabilise local currencies and cause local curves to invert.”

But the current turmoil, Mr Fiotakis said, is not being driven by EM fundamentals, but rather by funding strains in G10 countries. “If foreign capital inflows remain constrained independently, excessive rate hikes could prove less effective in stabilising local assets and could pose downside risks to growth in the medium term.”

Iceland raised interest rates on Tuesday by a massive 6 percentage points to 18 per cent in a bid to support the krona and please the International Monetary Fund, which Iceland has asked for a $2bn stand-by loan. The rate move mirrored a sharp tightening by the Hungarian central bank last week to stem a steep decline in the forint.

Hungary, which has also turned to the IMF for aid, warned on Tuesday that its economy could contract by as much as 1 per cent in 2009. But concerns about future emerging market growth were put to one side and the MSCI EM equities index bounced about 5 per cent off a four-year low.

“If foreign capital inflows remain constrained independently, excessive rate hikes could prove less effective in stabilising local assets and could pose downside risks to growth in the medium term.”

That seems to fit with this puzzle bit from “the internet”:

Meanwhile, Bank of England governor Mervyn King was particularly downbeat in a speech last night, highlighting that the recapitalization of the banking system was a result of an “extraordinary, almost unimaginable, sequence of events” which had been triggered by the Lehman’s collapse on Sep 15. He referred to the global credit crunch and the slowing in capital inflows into the UK, saying “…Unless they (capital inflows) are replaced by other forms of external finance, the adjustments in the trade deficit and exchange rate will need to be larger and faster than would otherwise have occurred…”

With domestic inflation rising, China allowed a faster appreciation against the depreciating dollar from November to March, and recently resumed such appreciation, albeit at a slower pace. In April, a month where the currency barely appreciated, China accumulated $75 billion in reserves, more than half likely speculative, short-term capital. With ‘hot-money’ on the rise, Chinese monetary and exchange rate policy becomes even trickier – and China is trying to make its appreciation path less predictable to deter inflows. Yet the 20% appreciation of the RMB since 2005 does mean that some of the heat is off – the latest installment of the U.S. China Strategic Economic Dialogue, which concludes today, is likely to focus instead on energy cooperation (U.S. and China are the two largest oil consumers) and a possible bilateral investment treaty. But with the interest rate differential between the US and China rising with each Fed cut, and the elevated costs of intervening in the foreign exchange market, the appreciation expectations are growing even if most trades no longer provide positive carry.

I'm with Fiotakis on slingshot 'recoveries;' watch out for the snap back. Volatility is only increasing. We can think about 'recovery' and 'a sustainable bottom' when volatility declines. Today's big run-ups look all to like pump-and-dump surges on the faux 'news' or [meaningless] Fed cuts. The Fed buying commercial paper is troublesome; at $60B it would appear it's near frightening. If the Fed is buying and the MMs aren't particularly, that is plenty indication we are still deep in the wilderness. I know, I know, "The Fed is trying to prevent a depression by the main force of its balance sheet." When that balance sheet is expended, as it very nearly is, without making any substantive improvement in this economic down cycle, we get to confront the 'night' of the downturn with a busted currency, too.

And consider this: Where is Iceland going to get the revenue to pay that 18% on their nationally owned banks? It's one thing to promise, another to deliver. Recall, if you will, those lip-smacking CD rates at the S & Ls pre-blowout. Iceland is looking too like a S & L with a deposit guarantee. Just so the Fed's promises: it all looks good, but where is the revenue to pay for all this?

“Hungary […] warned on Tuesday that its economy could contract by as much as 1 per cent in 2009.”Is that supposed to be a warning? I’d say they’re fortunate if they can walk away with such light damage to the economy.

Bank of England governor Mervyn King was particularly downbeat in a speech last night, highlighting that the recapitalization of the banking system was a result of an “extraordinary, almost unimaginable, sequence of events” which had been triggered by the Lehman’s collapse on Sep 15.

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Perhaps the governor should stoop to reading a few econ blogs like this one from time to time. Perhaps then it wouldn’t have seemed so “unimaginable.”

I would say demand destruction in western economies is only in the early stage. And for commodity producers and exporters of manufactured goods — which describes many emerging economies — that means bad news for a while.

I think the world govs/CBs are entering a period where interest rates will be increased in some countries to prevent currency flight. The IMF is demanding some countries to raise rates. Does the IMF realize that they could be adding to the risk of currency flight?